AEI scholar testifies on the designation of Systemically Important Financial Institutions

The following oral remarks were made by Peter J. Wallison, Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute, during a full House Financial Services Committee hearing on the Financial Stability Oversight Council (FSOC) and the Financial Stability Board (FSB):

Chairman Hensarling, Ranking Member Waters, and members of the Committee:

Thank you for the opportunity to testify this morning.

Under Dodd-Frank, the Financial Stability Oversight Council (FSOC) has the authority to designate any non-bank financial firm as a systemically important financial institution, or SIFI—if the institution’s “financial distress” will cause “instability in the US financial system.”

Firms designated as SIFIs are turned over to the Fed for what appears to be bank-like regulation.

The troubling aspects of the FSOC’s authority were revealed recently when it designated Prudential Financial as a SIFI.

Every FSOC member who was an expert in insurance (and not an employee of the Treasury Department) dissented from the decision.

Virtually all the other members, knowing nothing about insurance or insurance regulation, dutifully voted in favor of Prudential’s designation.

How could we entrust the decision to regulate a large insurer like a bank, to a group with no expertise about insurance regulations?

Even more troubling was the fact that the FSOC offered no facts, no analysis and no standards in in support of its decision.

For example, interconnections are supposed to be one of the main reasons characteritics of a SIFIs.

All financial institutions are interconnected, but the FSOC’s Prudential decision says nothing about the degree of Prudential’s interconnections or why they constitute a danger to the financial system.

The same is true of all the FSOC’s prior designations.

Let me say it plainly: This emperor has no clothes.

The FSOC seems to have no idea how to assess the danger of “interconnections” or any of the other reasons that SIFIs and are considered such a threat to financial stability that they require bank-like regulation.

This means its decisions are completely arbitrary, and sSince these decisions can have seriously adverse effects on competition and economic growth, they should not be allowed to continue until the FSOC can explain its decisions to Congress.

There are also other reasons to be concerned.

Two months before the FSOC’s Prudential decision, the Financial Stability Board (FSB), an international body of regulators empowered by the G-20 leaders to reform the international financial system, had already declared Prudential a SIFI—also without any facts or analysis.

Since the Treasury and the Fed are members of the FSB, they had already approved the FSB’s designation well before the FSOC designated Prudential as a SIFI in September.

This raises two questions: First about the fairness and objectivity of the FSOC designation process, and second whether the FSOC will simply “rubber stamp” the decisions of the FSB in the future.

This is important because the FSB looks to be a very aggressive source of new regulation of nonbank financial firms.

In early September, the FSB published plans to apply what it called its “SIFI Framework” to “securities firms, finance companies, asset managers and investment funds, including hedge funds.”

These firms are the so-called “shadow banks” that bank regulators are so eager to regulate.

It will be very difficult to show that these nonbank firms pose any threat to the financial system, but the Prudential decision shows that neither the FSB nor the FSOC believes it has any obligation to do so.

As others have said this morning, collective investment funds are not like the banks or investment banks that suffered losses in the financial crisis.

But the question before this committee is not solely whether investment funds are SIFIs.

The FSB has already suggested it will apply the SIFI Framework to securities firms, mutual funds, hedge funds and many others.

If the FSOC follows suit—and that has been the pattern—we may see many of the largest non-bank firms in the US financial system brought under bank-like regulation.

As shown in my prepared testimony, these capital markets firms—and not the banks—are the main funding sources for US business.

Subjecting them to bank-like regulation will reduce their risk-taking and innovation, and thus have a disastrous effect on competition and economic growth.

And this outcome would be the result of decisions by the FSB, carried out by the FSOC.

About two weeks ago, Mr. Chairman, you said the FSOC should “cease and desist” on designations until Congress can assess the consequences.